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Power Procurement: What's in Your Mix?

Why competitive markets are scaring regulators.

Fortnightly Magazine - November 2006

supply and demand at the time of their electricity needs. That is, there are components of the price that are passed through to customers ex post, such as fuel and purchased-power costs incurred in short-term market transactions, which create an average cost that includes important purchases necessary to balance supply and demand.

One of the key differences between the portfolio-resource-mix approach and the competitive-solicitation approach is the greater propensity to obtain longer-term commitments under the portfolio-resource-mix approach. The practical implication of this difference is the registration of demand in the longer-term wholesale market. Although these portfolio resource-mix procurements have been observed over recent years to produce more longer-term supply commitments, 9 the approach itself is a closely regulated risk-management strategy.

Once longer-term commitments are made, utilities still must buy and sell electricity to balance their systems, and these transactions require explicit risk-management procedures to be in place so that regulators can be assured that utilities’ power purchases are not exposing customers to unnecessary risks. In essence, the portfolio-resource-mix approach does not provide price certainty to the buyer; instead, the utility is in the position of constantly buying and selling in daily, weekly, monthly, and even yearly wholesale markets to balance the underlying resource mix. The regulator must then rely on detailed procurement policies (including reliance on complex modeling tools and financial risk assessments), and must conduct periodic prudence reviews to ensure that the utility has acted consistent with state regulations. The important observation is that the procurement approach in states without retail competition requires the regulator to explicitly oversee this risk-management policy.

Tradeoffs Among State Procurement Approaches

The tradeoff between the portfolio-resource-mix approach and the competitive-solicitation approach appears to be between maintaining system reliability and ensuring that costs associated with generation are minimized over the long-run. The portfolio-resource-mix approach may be viewed as more reliable because of the ability of the regulator to approve plans for new generation supplies, but may entail significantly higher electricity costs if utilities with regulatory oversight make poor planning decisions. The competitive-solicitation approach may be viewed as less reliable because of the reliance on the wholesale market to plan generation supplies, but should entail lower electricity costs since competition is the driving force. There is no evidence that reliability will be compromised under either approach. We believe the heart of the debate is over which approach will minimize consumer electricity expenditures over the long-run.

Both procurement approaches rely heavily on a competitive wholesale market for generation supplies. The key difference is how risk is managed. For example, under the competitive-solicitation approach, risk often is managed by soliciting ex ante fixed-price products, such that all costs to serve customers are known; under the portfolio-resource-mix approach, prices of some resources are not fixed and customer costs vary over time. Due to ongoing debates regarding the ability of organized wholesale markets to signal the need for new generation supplies, there is a tendency to overlook the actual happenings in the procurements themselves. Here we set aside the debate on wholesale market structure and focus on the risk-management issues that are